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Should interest rates be higher?

Although the Federal Reserve continues to see ample slack in the U.S. economy, some measures suggest interest rates should be considerably higher at this point in the recovery. CBS MoneyWatch contributor Anthony Mirhaydari explains
Fed off the mark on interest rates? 01:07

The Federal Reserve reiterated last week that it will persist with it's soft-handed approach to inflation, dismissing the recent rise in prices as "noisy" and not something to worry about. Given the choice between rattling complacent investors and a vulnerable economy, and taking a wait-and-see approach to prices, the Fed has decided to wait.

The trouble is, economists including Allan Meltzer at Carnegie Mellon and John Taylor at Stanford University are growing increasingly concerned. The former recently penned an op-ed in the Wall Street Journal warning the rising food price inflation -- which are rising at the fastest rate since August 2011 -- will likely usher in broader, more intense price increases throughout the economy.


A simple calculation known as the "Taylor Rule" created by John Taylor suggests that the Fed is falling behind the curve on interest rates by keeping them too low for too long. To be sure, inflation today remains modest by historical standards. But in seemingly downplaying inflation, the central bank could set the stage for an uncontrollable surge in prices down the road.

The Taylor Rule tries to formalize monetary policy by setting interest rates based on where the economy and inflation is. This is a goalpost. And for those who use it, it provides a measure with which to benchmark the Fed's performance.

The calculation reveals two truths: The economy is closer to full capacity than is commonly acknowledged and inflation has quickly returned to its target. And that means the Fed is dragging its feet on getting interest rates back to where they should be -- raising the risk of not only a wave of inflation but fueling another asset price bubble as it did during the housing bubble.

First, let's talk the economy. Currently, the Congressional Budget Office estimates that the U.S. economy's full potential output at the end of the first quarter was $17.9 trillion, versus current output of $17.1 trillion. So we're running about 4.7 percent below capacity.

Next, inflation. The Fed, for better or worse, believes long-run inflation should be around 2 percent. Current consumer price inflation is at 2.1 percent.

Unfortunately, interest rates are at zero percent now and have been since 2008. Even if the Fed were to raise rates to nearly 2 percent overnight, which would never happen, it would still take nine months or so for the change in rates to filter through to the economy. That's the delay inherent in the transmission of monetary policy into the economy.

Currently, the Fed doesn't expect rates to hit this level until sometime in 2016. It risks a bigger problem down the road by avoiding a little bit of pain from raising rates right now.

Because the formula is so sensitive to changes in the inflation rate, the more inflation rises, the wider this gap will become. And the wider the gap becomes, the faster inflation will rise since the Fed is keeping interest rates too low for where the economy and inflation is.

Meltzer warns that the last time the Fed fell behind the curve on inflation to this extent and held short-term rates below the inflation rate was in the run up to what he has dubbed the "Great Inflation" of the 1970s. That ultimately led to the twin recessions of the early 1980s and 20 percent plus interest rates as I discussed in a recent post.

Until the Fed gets in front of the situation, by increasing interest rates to or above the level suggested by the Taylor Rule, precious metals should continue to do well as investors seek inflation protection. This will lift silver and gold ETFs including the iShares Silver (SLV), which is up more than 11 percent for my clients this month. Or mining stocks like NovaGold (NG), which is up nearly 17 percent since I added it to my Edge Letter Sample Portfolio back on June 5.

Disclosure: Anthony has recommended SLV and NG to his clients.

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